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Retirement funds tapped for kids' tuition

By Jennifer Liberto, senior writerOctober 5, 2010: 9:53 AM ET

WASHINGTON (CNNMoney.com) -- Nearly a quarter of the nation's parents saving for their children's college education intend to raid their own retirement accounts, despite increasing their tax liability, according to a new study released Tuesday.

The results of the survey, conducted by student loan provider Sallie Mae and the Gallup organization, surprised personal finance experts - especially considering other options, such as 529 college savings plans, that can grow and be spent on college education tax free.

Some 24% of parents said they planned to save for college by dipping into retirement accounts, such as 401(k)s, IRAs and pension plans. The same percentage, 24%, said they plan to use 529 accounts.

"I find it a little odd and disturbing, because if you're going to save for college, there are a number of ways to do that with tax advantages," said Mari Adam, a certified financial planner with Adam Financial Associates Inc., of Boca Raton, Fla. "They're probably planning on using their retirement accounts, because it's what they have available."

The main problem with raiding retirement accounts for college is that it triggers big tax penalties compared to other types of investment plans. Even taking a loan out against a 401(k) can be dangerous, because it has to be paid back within 5 years, or immediately when the borrower changes jobs.

Also, when retirement accounts are tapped for college, that money counts as adjusted gross income and will reduce the amount of financial aid a family qualifies for the following year by as much as 47%, according to Mark Kantrowitz, publisher of Fastweb.com and FinAid.org.

"They will net very little of that money back. It's kind of a desperation move," Kantrowitz said. "There are times that families are struggling a little bit more and that's why they are tapping 401(k)s."

Parents aren't just planning on tapping retirement accounts in the future, they're actually dipping into them more often, according to a different survey.

During the 2009-2010 school year, 6% of parents surveyed said they drew down their retirement accounts to pay for college, a figure that rose from 3% the prior year, according to an August survey conducted by Gallup and Sallie Mae (SLM, Fortune 500).

Despite the sputtering economic recovery, 60% of parents say they're saving for their children's college education, socking away an average of $28,000 so far, according to the study conducted by Sallie Mae and Gallup. By the time their kids are ready to go to college, most parents will have saved about $48,000 on average.

The most common way that parents reported saving for college was with CDs or general savings accounts. Some 50% used those more traditional forms of saving, according to the survey.

The second most common kind of investment tools were investments such as stocks, mutual funds and money market accounts, used by 34% of those saving for college, the survey said.